Premium Financing Quantified Models & Implications for Leveraged Life Insurance Transactions

Bobby Samuelson

SamuelsonDesign

8/21/11

Abstract

No life insurance sales strategy has been as hotly contested as premium financing. The practice of borrowing

money to purchase large amounts of life insurance pervaded the market prior to 2008 and has recently found new

life with ultra-low interest rates, creative new financing strategies and products focused on the financing market.

This paper primarily attempts to build a framework for analyzing the impact of financing on life insurance returns

both in static and dynamic conceptual models. Secondarily, the paper will address use of premium financing with

specific premium and face designs, Indexed UL products and in estate planning.

Outline

1. Introduction to Premium Financing

2. The Pure Traditional Premium Financing Model

3. Dynamic Variables in the Model

a. Loan interest rates

b. Loan fees

c. Collateral

d. The Retained Capital Illusion

4. Implications

5. Policy Design in Premium Financing

a. Return of Premium

b. High Early Cash Value

6. Indexed UL and Premium Financing

7. Summary

Disclosure

All words herein are solely mine unless specified otherwise.

I did not receive any compensation from any party, directly or indirectly, for authoring and publishing this piece.

I do not claim to be an expert in the details of specific premium financing arrangements. My comments are geared

towards the general theory, not a particular collateral or loan interest arrangement.

This white paper is for open distribution.

Introduction to Premium Financing

Premium financing is the use of third party capital to purchase life insurance. The premium financing spectrum

could be defined by traditional premium financing on one end and non-recourse premium financing on the other.

Traditional financing is structured as a fully collateralized, on-balance-sheet loan arranged by the insured or a

trust established by the insured. Non-recourse premium financing is a loan typically collateralized by the

theoretical value of the policy upon settlement in the secondary market. So-called “hybrid” arrangements involve

partial collateral posted by the policy owner and some measure of recourse from the lender to the policy owner.

Hybrid and non-recourse premium financing arrangements are typically geared to take advantage of a projected

arbitrage between the cost of premium payments and the value of the policy in the secondary market. The

sometimes spectacular blowups of these arrangements have been well documented in various major news outlets

such as the Wall Street Journal and in the slew of lawsuits alleging fraud, misrepresentation and a variety of other

abuses. This paper addresses only traditional premium financing, as defined by full-recourse, fully-collateralized

financing typically used in estate and business planning.

Traditional premium financing is marketed in two distinct ways. It is either positioned primarily as a means to

minimize gift tax friction (effectively trading gift taxes for loan interest payments) in transfers of property to trust

or as a way to increase the rate of return of the life insurance transaction. Financing arrangements used to reduce

gift tax friction typically are shown in conjunction with another estate planning techniques that have the potential

to dump assets into the trust at a later date free of gift taxes. The future trust assets are usually structured to be

large enough to pay off the original loan amount and to continue paying premiums in on the contract. As such, the

economic impact of the financing arrangement itself on the economic viability of a life insurance policy held in

trust is a secondary consideration. Financing only serves as a vehicle to reduce gift taxes.

In the latter case, however, premium financing serves as a key reason for the purchase of the life insurance policy

itself. Financing allows for projected internal rates of return through a certain period to be substantially higher

than the base life insurance policy. It also is often positioned as a way to minimize out of pocket costs early on by

trading out-of-pocket premium payments for loan interest costs. In other situations, the insured (or the trust)

accrues loan interest to delay payment for several years. When premium financing is marketed as a return

enhancement technique, the long term performance of the strategy is almost entirely predicated on the rate

spread between the policy returns and the loan interest cost. Premium financing used as a marketing technique

places the focus on the financing arrangement; premium financing as a vehicle for reducing gift tax friction places

the life insurance policy at the focal point.

This paper focuses primarily on premium financing as a marketing technique. Its goal is to explore the economic

impact of leveraging life insurance through third party premium financing, analyzing the ways in which changes in

financing and product assumptions and designs change outcomes.

The Pure Traditional Premium Financing Model

The best way to analyze the economics of a premium financing transaction is by first by manipulating a simple,

static model and then adding more complexities and dynamic assumptions. The starting model is as pure to the

basic concept as possible – the insured borrows money to pay life insurance premiums. Many premium models in

the marketplace use a variation of this type of simple, static model.

The math is strikingly simple. The life insurance illustration provides premium, death benefit and cash value

figures. The loan is assumed to be available in every year and at a constant rate throughout the length of the

illustration. Posted collateral is assumed to have no transaction cost (such as a letter of credit fee or loan

arrangement fee) and no opportunity cost (posted collateral earns the same as free capital). In this case, the client

pays or accrues loan interest instead of paying premiums and receives the death benefit net of the loan balance.

Table 1 shows a pure premium financing model with labeled columns.

Columns A, B and H are from the life insurance illustration. Cash surrender value is assumed to be zero.

Practitioners will note that the design of the policy in this example has a level death benefit whereas most

premium financed policies have Return of Premium (Option 3) death benefits. This will be addressed in a later

section. Column F shows the out of pocket cost of the loan in every year. If loan interest is fully accrued, column F

would be zero. Column G doubles as the loan balance at the end of the year and, by extension, the total amount

of collateral that needs to be posted by the end of the year. Column H, policy cash values, offsets required

collateral but the remainder, Column I, must be posted by the client. Column J is the total cost for the financing

arrangement which, in this case, is only the interest cost. Later models will include more costs. Column K is the net

benefit that the client (or his trust) receives upon death. The death benefit first goes to pay off the outstanding

loan balance and the residual is kept by the beneficiaries.

The pure premium financing model allows for direct comparisons of the economics of a life insurance policy

funded out of pocket and a premium financing arrangement in a static universe, which is the way the life

insurance illustration almost always projects policy values. What should become readily apparent is that the life

insurance policy offers a level premium and a level death benefit whereas a premium financing arrangement

offers lower cost at earlier years in exchange for lower death benefit in the later years. In the example above, the

life insurance premiums total $4,837,483 in the first 10 years and the client has $15 million of death benefit. The

financing arrangement has a total cost of $1,064,246 in the first 10 years and the client receives between $14.5

million and $10.1 million in net death benefit. By the 20th year, the client will have paid $9.67 million in premium

for $15 million of coverage for the out-of-pocket policy and $4.06 million for $5.3 million in net death benefit with

the financed policy.

The real question is, from a return standpoint, which is the better deal for the client? Time value of money

provides some insight. Life insurance policies are often sold on premium comparison. The problem with simply

comparing cumulative premiums across an out-of-pocket and a financed policy is that the costs and benefits for

the financing arrangement are not static. A dollar tomorrow is worth less than a dollar today, hence, the fact that

premium financing costs so little today is a real benefit even if costs jump and benefits fall in the future. An

internal rate of return calculation creates a means for apples-to-apples comparison between financed and non-

financed policies. Internal rate of return is the assumed discount rate needed for a stream of opposing cash flows

to have a zero net present value.

Premium financing allows for another way to shape the policy internal rate of return curve. By applying leverage,

early returns are higher than the policy itself and later returns are lower. Leverage amplifies the returns inside of

the policy. The pertinent issue is when and how the returns are amplified and what assumptions are made in

projecting the future internal rates of return for the financing arrangement. The answer is exceedingly simple. In a

pure premium financing arrangement, the financing arrangement has a higher IRR than the policy for as long as

the static loan interest rate is higher than the policy IRR. If interest is accrued, the death benefit net of the loan

stays positive for as long as the policy IRR is greater than the loan interest rate. The conclusion is logical. IRR

calculates the effective yield on premiums, also interpreted as the opportunity cost of capital hurdle for making

the life insurance a positive net present value proposition. Leverage only works to amplify returns if the

opportunity cost of capital, the investment, exceeds the cost of capital, the loan rate. Premium financing is

therefore essentially a swap between the IRR on policy premiums and the loan interest rate. As such, when the

IRR exceeds the loan interest rate, the client is in-the-money on the swap. When the IRR falls below the loan

interest rate, the client is out-of-the money.

Table 2 shows IRR figures for financed and non-financed policies at different loan rates on a pure financing model.

Note that the crossover year for each premium financing scenario is exactly the year in which the policy IRR drops

below the loan rate. This relationship is true for every policy design, including Return of Premium face options and

skip pay premium designs, the two most commonly used in traditional premium financing.

Dynamic Variables in the Model

The addition of dynamic variables merely modifies the axiom that a premium financing arrangement is a swap

between the policy IRR and the loan rate by adding more components to the cost of the financing arrangement.

Assumptions within the pure model do not hold up to real world outcomes. Loan interest rates do not stay

constant. Loans may entail arrangement fees. Collateral often has explicit charges for being posted and

opportunity cost. Policy performance in a non-guaranteed product may be less than or greater than illustrated.

The client may not be able to obtain financing at a later date. These factors amount to the introduction of risk

factors into the premium financing models. The pure model is a strict swap arrangement that, if possible in the

real world, would be an easy decision. Clients would fund No Lapse Guarantee (NLG) products with priced rates of

return higher than a fixed loan cost that extends for the life of the policy and realize significant arbitrage except in

scenarios when the client lives much longer than the average. Mortality would be the only risk factor. The

variability of the real world negates that scenario.

Variable Loan Interest Rates

The first step in making the pure financing model better fit the real world is to show variable loan interest rates

that should accurately reflect the behavior of past loan interest rates. Typical premium financing arrangements

are priced as a spread over the 1 year London Inter Bank Offered Rate (LIBOR), usually 1 year LIBOR plus 100-

250bps. As interest rates have fallen to historical lows, financing arrangements have also been priced on a 30 day

LIBOR basis with a 300bps or more spread and a floor of 4%. Swaps are sometimes available for 1-10 year

durations. For modeling purposes, the Prime one year rate can also serve as a substitute for the various different

financing strategies with one year interest durations.

Table 3 shows the premium financing model under static assumptions and dynamic assumptions. The policy

premiums are a current (7/5/11) quote of a competitive NLG policy at Preferred. The historical distribution

projection assumes randomly distributed interest rates that follow a normal distribution with a mean and

standard deviation that match the 31 year historical data. The mean is 8.38% and the standard deviation is 3.04%.

Note that the pure financing model with the static interest rate assumption follows the same rule as before. The

IRR of the financing arrangement falls below the policy IRR when the loan interest rate is greater than the policy

IRR. In the historical distribution scenario, the financed IRR drops below the policy IRR after only 16 years and

goes negative at year 19. The reason is the same as in the pure model – the policy IRR dropped below the

arithmetic average of the previous loan rates. The key to dynamic interest rate modeling is that it captures the

characteristics of historical interest rates. Static models show that rates will stay constant, historical models

assume that history will repeat itself exactly and dynamic models assume that interest rates will generally behave

as they did in the past, although the actual future performance is unknown.

Loan Fees

Fees for arranging loans or securing a line are common. In more complex financing arrangement, fees are often

incurred simply for rolling the loans from year to year. The impact of any loan fee on the pure financing model is

straightforward. Loan fees reduce premium financing IRR figures analogously to rising interest rates. Imagine if,

instead of charging a direct fee, the bank simply added basis points to the interest rate that equal the same dollar

amount as the loan fee. The impact on the client would be largely identical. Therefore, loan fees serve to

negatively impact premium financing IRR figures in excess of the pure financing model in every situation. The

question as to whether the client is better off accepting a long-term higher loan rate or an up-front loan fee

should be handled by the producer and the client’s advisors.

Loan fees are typically a small piece of the premium financing transaction. However, recent complex

arrangements have introduced large loan fees in exchange for a chance at lower interest rates over the long term.

A recent proposal contained more than $1.5 million in loan fees over the first 10 years on a $50 million policy for

a 54 year old. The actual financing loan rate was illustrated at a constant and meager 4.00%, more than 4.3%

lower than the historical average Prime rate. Buyers should be aware of any and all fees rolled into the loan

arrangement and consider those fees to be a drag on their long term rate of return for the structure.

Collateral

The process of posting collateral for premium financing arrangements can be fraught with hidden costs and risk.

Policy cash values often provide full collateral offset in arrangements where the client pays interest and the

financed policy is specifically designed for premium financing strategies. However, as will be discussed in a later

section, policies built for financing have a different set of risks. Collateral comes into play most when the policy is

designed to have efficient premiums and low/no cash value and when the client is accruing loan interest, against

which collateral must be posted. Additionally, some new premium financing structures specifically require

immediately liquid assets and policy cash values do not qualify. As such, collateral must be posted for the entire

loan balance regardless of the policy cash values. The client theoretically receives a lower loan rate in exchange.

The essential requirement for collateral is that it is highly liquid. Cash is always accepted and many low-risk

marketable securities are as well. In the event that the client does not have enough cash or high-liquidity

marketable securities on hand, the bank can arrange a Letter of Credit (LOC) by which the issuing bank is

responsible for posting liquid collateral. In exchange, the client can use less liquid assets to secure the LOC but

must pay the bank a fee. One percent is a traditionally understood “reasonable” LOC fee, although the price can

bounce drastically and did when bank balance sheets were over-extended in the recent recession.

Collateral has another, less obvious cost. Assets posted as collateral are impaired and cannot be placed into

illiquid investments. Premium financing is often justified as a way to get insurance coverage without losing the

earnings in other, higher yielding investments. However, assets such as shares in a closely held business are

difficult to value and not liquid quickly enough to qualify for collateral. An LOC may be secured with a fee or the

client must liquidate shares. Both premium financing and paying premiums out of pocket have the same potential

impairment of assets. Premium financing requires collateral whereas premium payments require cash out of

pocket. Both can have identical opportunity costs of capital if collateral is impaired for investment purposes.

Table 4 compares the out-of-pocket policy IRR, the pure premium financing model IRR and the premium financing

model IRR including Letter of Credit fees at 1% of collateral and a loan arrangement fee of 1% of annual premium.

Note that modest fees add a substantial drag to the premium financing IRR. Whereas the pure premium financing

model falls below the policy IRR at age 92, the model with costs falls below at age 90. The difference between IRR

figures for the pure and the cost model are close to 3% beyond the 16th year.

The Retained Capital Illusion

Premium financing proposals are frequently shown with a section for “retained capital,” meaning the difference

between what the client pays for the premium financing arrangement versus what he would have paid out-of-

pocket for the policy. The proposal invariably shows the retained capital growing at some rate in excess of the

loan interest rate and simultaneously ignores the cost and opportunity cost of posting collateral. The premium is

either paid out-of-pocket or is posted as collateral to the degree that policy cash values do not cover it. In either

case, the full premium can be impaired for investment purposes if cash value is zero. Impaired premium

theoretically cannot earn more than the bank is charging because that would violate the simple banking principal

that it charges more to lenders than it credits to savers. In the case of cash posted collateral, the client is both a

lender and a saver and the spread goes to the banking system. Other collateral, such as bonds or stocks, must be

posted at a lower margin, impairing a larger piece of the client’s assets. In the case of letter of credit collateral, a

fee would be incurred for posting collateral and the collateral itself would have limited investment opportunities

because liquidity would still be paramount. Retained capital in excess of the capital freed by policy cash values is

an illusion. But, in the case that we entertain the illusion, the economics are less than exciting.

The basic retained capital calculation often used in premium financing proposals is policy premium minus loan

cost. The premium financing benefit with retained capital is the death benefit net of the loan plus the retained

capital account. In other words, retained capital operates as follows.

Annual retained capital = premium – loan interest cost

Retained capital account = (last year’s retained capital + annual retained capital)* (1+ assumed rate of interest)

Financed benefit = (policy death benefit – net loan balance) + retained capital account

The assumption we make and that is usually present in the retained capital model is that interest is paid at the

beginning of the year (in advance). It is a reasonable assumption given that insurance premiums need to be paid

at the beginning of the year. that interest is paid in arrears changes the outcome of the transaction and provides

additional benefit for using a retained capital account. The best way to illustrate the retained capital accounting is

to show the loan interest exiting at exactly the same time that the retained capital interest is earned, as opposed

to before (advance) or after (arrears). Under this accounting method, assuming a 4% loan interest rate and a 4%

retained capital earned rate yields a total financing benefit identical to the death benefit. The analysis below

assumes payments in advance to equate interest cash flows to premium payments.

Table 5 outlines a pure premium financing model with a retained capital account and advanced interest.

The retained capital account, in this case, is a boon to the IRR of the transaction. The illustrated performance gain

comes from the difference between the assumed rate of return on returned capital and the loan interest rate, as

Table 6 clearly demonstrates.

In short, the only way retained capital can benefit the client from a return standpoint is if the earnings on retained

capital are greater than the policy because the retained capital fund assumes the same cash inflows flows as the

policy itself. Leverage, in effect, ceases to exist. The retained capital merely allocates part of the premium, the

interest payments, to the policy and the rest to a side fund. The client could realize benefits if from high retained

capital earnings if collateral is covered by the cash value, freeing retained capital to go to riskier investments, and

loan rates stay low. Ironically, the question becomes why the client bought insurance based on projected financed

rates of return if, in fact, he was so confident that the retained capital performance would exceed the loan rate

and most likely the policy rate of return. The logical choice in that situation would be to borrow money and invest

it in whatever assets comprise the retained capital account. Perhaps the primary benefit of a retained capital

model is that the client theoretically maintains a more liquid position to the extent that the retained capital

account exceeds the loan balance, assuming the policy has little or no cash value. If the policy has cash value then

the retained capital strategy provides excess liquidity only when it exceeds the cash value.

Finally, the retained capital model is often posited as a way to hedge future loan rates. The idea is that rising loan

rates will reduce the attractiveness of the original premium financing arrangement but will be at least neutral for

the retained capital account.

Table 7 shows the impact of variable interest rates on the performance of a model with retained capital.

The final two columns illustrate the amount the client would have lost, all in, by surrendering the policy with no

cash value. One can assume that a rising interest rate would incent a client to switch to a different policy based on

the higher interest rates if he has remained similarly insurable. The retained capital account does provide a high

level of liquidity in the early years which could be extremely valuable if interest rates do, in fact, rise.

Retained capital accounts appear to provide one major benefit to clients – liquidity when financing a low-cash

policy, typically a no-lapse guarantee contract. Arguments regarding the ability of retained capital to earn a rate

higher than the loan rate bump into practical considerations of collateral requirements and theoretical issues of

why a client would choose to lever a life insurance policy instead of the supposedly high yielding assets.

Implications

The axiom repeated numerous times in this paper is that premium financing is merely a swap between the

interest rate of the loan and the return of the policy, compounded by the direct cost and lost opportunity cost of

posting collateral. Leverage through financing amplifies both positive and negative returns but does not change

the return structure of the levered asset. With leverage, gains and losses occur at the same frequencies but in

greater magnitudes. Accordingly, leverage is best applied when the leveraged asset has a higher probability of

success due to at least the semblance of an arbitrage opportunity. The pertinent question for premium financing

is when, if ever, arbitrage opportunities occur in life insurance. Whereas the prices of tradeable securities are

generally arbitrage-free because of market forces, life insurance operates in a vacuum. There is no active trading

to help carriers determine whether or not their product is underpriced. Ironically but not paradoxically, the best

indication that a product is underpriced may be that it has a high share of the market in sales.

Leveraging life insurance returns is a bet that the life insurance company has made at least one grievous pricing

error by either underpricing the client’s mortality by assigning the wrong risk class or universally mispricing the

product to provide a return that is larger than current borrowing rates. The most likely is the former error because

it is a specific rather than a general error. It is more likely that a carrier makes a mistake on a single client than on

a product as a whole. If an agent has reason to believe that the carrier has misjudged mortality by a substantial

margin, then the policy IRR at projected life expectancy can be leveraged and the transaction will be more

efficient to the client than paying premiums out of pocket. The risk to the client is that his mortality looks like

what the carrier priced and the leverage will turn against him.

The broader type of potential arbitrage opportunity is between the priced rate of return in the life insurance

contract and the loan rate. The axiom that premium financing only works as a return enhancement vehicle if the

loan interest rate is below the policy rate of return. Premium financing proponents often illustrate an arbitrage

opportunity either by making aggressive mortality assumptions (50% Life Expectancy) or long term loan rates well

below historical averages. Theoretically, arbitrage opportunities between loan rates and insurance policy yields

should be hard to find. Personal loan rates and corporate loan rates (bonds) are priced off of the same underlying

risk-free rate, both with a spread that reflects creditworthiness and duration of the fixed loan rate. Insurance

companies invest mostly in high quality corporate loan rates that, in theory, should carry lower interest than

personal loans which are generally more prone to default. The lender can also look to the insurance company’s

balance sheet for the credit quality of the loan if cash values are expected to provide most of the collateral. Even

in this best case scenario, it is unrealistic to believe that personal loans will carry interest rates below corporate

debt. Given that insurance policies are priced largely off of corporate debt, premium financing is immediately

biased to have a higher loan rate than policy rate of return.

Furthermore, carriers build policy charges and investment spreads to ensure that the product is profitable

assuming an earned rate that is equal to the current earned rate on assets. Life insurance carriers have many

incentives to pull down policy returns whereas banks have many incentives to raise loan rates, collateral costs and

loan fees as much as possible. Premium financing illustrates a positive spread between the loan rate and the

policy IRR that has all forces pushing the two variables towards a negative spread. No Lapse Guarantee presents

the only way for a client to limit risk by locking the rate of return on the life insurance policy. But NLG is far from a

perfect product for financing. It soaks up collateral the size of the loan balance and is currently priced off of

historically low interest rates. Financing an NLG product presents an opportunity for an all-or-nothing bet that

interest rates will stay low or fall further, hardly an enticing prospect when short term rates are already near zero.

Policy Design in Premium Financing

Universal Life products allow for premium and face value flexibility that can substantially benefit the economics of

a premium financing transaction and may present small arbitrage opportunities. The most common of these are

Return of Premium (ROP) death benefit options and skip premium funding patterns. Product selection for

premium financing must balance the need for collateral relief in the form of high policy cash values with the goal

of leveraging high death benefit returns. Current Assumption UL (CAUL) is the most common choice for a cash rich

product and NLG is used to leverage high, guaranteed death benefit returns. More recently, practitioners have

found what many perceive to be a best-of-all-worlds solution of high cash value and high death benefit returns

with Indexed UL.

Return of Premium Death Benefit Options

Producers and premium financing marketers usually present Return of Premium (ROP) death benefits as a way for

the client to receive a level death benefit net of the loan balance if interest is paid completely out of pocket.

While this is certainly true, the more relevant fact is that ROP death benefit policies consistently have a higher

rate of return than level death benefit policies. Higher policy returns are magnified through illustrated leverage

and bolster the conception in the market that premium financing itself is the cause of higher life insurance

returns. On the contrary, the additional return from a leveraged ROP policy comes exclusively from the higher

returns generated by the ROP itself, which the client could buy out of pocket if he so chose.

Table 8 illustrates the impact of an ROP policy on the leveraged returns from premium financing.

The storyline for premium financing typically compares the level face policy with the financed ROP policy because

the net death benefit to the client is identical. Not surprisingly, premium finance appears to generate substantially

higher returns than the level face policy. The better comparison is Table 8, which shows both policy options

financed and unfinanced, and makes the relationship between loan interest rate and policy return very clear.

A policy with Return of Premium almost always generates higher return than a level face policy. The tradeoffs are

relatively few. The client must be underwritten for the full final face amount of the policy, which can be a major

problem for subsets of wealthy clients. Agent compensation is based on the original face amount, not the full final

face amount. The client is technically buying a product that has a drastically increasing death benefit but only

receives the base face amount. Premium financing generates higher returns on a smaller number (the net death

benefit) from a policy that has slightly lower returns on a much larger number (the gross death benefit). Finally,

financing with Return of Premium can create the illusion that the client is really buying a level face policy out of

pocket and the costs are accordingly small. The reality is that the client is saddling his balance sheet with the

much higher ROP premium. Nonetheless, Return of Premium is the closest to arbitrage in policy design in the UL

universe. Its tradeoffs are relatively few but its returns are high. As such, a policy with ROP makes a much better

financing vehicle than a level face value policy.

The axiom that IRR from premium financing is a direct relationship between the all-in loan cost and the policy IRR

still holds for financed ROP policies. Note in Table 8 that the IRR crossover point for the level face policy is at Age

92, when the policy IRR slips below the assumed pure loan rate of 4%, and the crossover for the ROP policy is at

Age 99, when the ROP IRR falls below 4%.

Table 9 provides more evidence by comparing financing arrangements at 5% and 6%.

In short, Return of Premium has attractive characteristics but follows the same economic rules as level face

financing. It simply provides a larger buffer for rising interest rates through a higher policy IRR, which the client

could still receive by paying premium out-of-pocket if he so desired.

High Early Cash Value Designs

Premium financing promoters have recognized the truism that posting collateral is one of the biggest roadblocks

to a financed sale. Carriers have issued a plethora of products focused on early cash values in response. The

tradeoff for collateral offset is that the funding patterns required to achieve it diminish the death benefit IRR over

the long term and cause higher interest payments earlier in the transaction. High early cash value products also

typically lack meaningful guarantees and subject the client to the possibility that the carrier’s ratings fall and the

bank no longer gives full credit to the policy cash values, thereby forcing the client to post collateral for the

difference. Finally, these products often have policy charges that are higher than market averages for products

not designed for premium financing. The effect for the policyholder is twofold. First, that the product’s

performance is more focused on the cash values as opposed to the death benefit, and the policyholder can expect

the product to have relatively lackluster performance in funding patterns designed to amplify death benefit IRRs.

Second, the product is highly sensitive to crediting rate volatility, increasing the risk that an adverse change in the

crediting rate could impair the policy to the point where additional collateral (or policy surrender) is required.

Table 10 compares IRR figures for a level face policy purchased out of pocket and a financed Return of Premium

policy with high early cash values. Note that the ongoing interest cost for the financed policy is greater than the

NLG premium. The additional collateral in later years is due to declining cash values.

Table 11 matches the assumed financing loan rate to the current policy crediting rate, simulating a loan rate that

is closer to historical averages.

In short, early cash value designs reduce collateral constraints but reduce policy IRR, and therefore premium

financing IRR, to a level more like an out-of-pocket level pay, level face policy. Furthermore, high premiums up

front also mean that, under a rising interest rate scenario, the cost of the premium financing arrangement could

actually exceed that of a level pay contract. High early cash value designs can also be combined with Option 2

death benefit, where the death benefit is equal to the cash value plus the original underwritten face value. This

design provides additional net death benefit insofar as the cash value exceeds the cumulative premium payments,

a common situation in overfunded policies. The additional risk of an Option 2 death benefit is that the policy is

more fragile to crediting rate changes due to higher Net Amount at Risk and that the death benefit does not

exactly match the loan balance, potentially resulting in a net payment to the heirs of less than the base face.

Indexed UL & Premium Financing

Indexed UL products allow the highest illustrated rates in a non-securities life insurance product. Given that

premium financing illustrated performance is derived from the spread between policy returns and the loan rate,

Indexed UL is an exceptionally attractive vehicle for the strategy. Illustrated rates in Indexed UL products range

from 6.5% to over 10% and loan rates are generally shown at 3% to 6.5%. Most of the premium financing

arrangements with Indexed UL being marketed through specialty firms share the common characteristic of being

shown with little or no outlay from the client except for posting collateral. The strategy is quite simple. If Indexed

UL is illustrated at 9% and the loan rate is illustrated at 4% forever, the 5% spread between the two illustrated

rates essentially covers all costs of securing the coverage. The client is shown to pay nothing out of pocket.

Table 12 shows figures from an actual premium financing illustration I received from a major provider and is

indicative of most of the other premium financing with Indexed UL illustrations I’ve seen.

The policy crediting rate was illustrated at 9.17%. Loan fees include any costs that wouldn’t exist in an out-of-

pocket arrangement such as letter of credit fees. All costs are accrued into the loan balance during the first 10

years. After that, all costs are paid by a loan from the policy.

Table 13 outlines the sensitivity of the arrangement to adjustments in the assumed rates. Loan rates are assumed

to match the above illustration for years 1-10 and adjust to the specified new rate in year 11.

Note that outcomes are extremely sensitive to the size of the illustrated arbitrage. Furthermore, these

arrangements assume static crediting and interest rates and would almost certainly perform worse under variable

rate conditions which we can’t illustrate due to statutory limitations in the Indexed UL illustration system. Note

also that the lender has recourse to the client for the full loan balance in excess of cash values. In the event of a

policy lapse, the client would receive no net death benefit, potentially phantom income tax costs on the

distributions and would owe the entire loan balance (in excess of $48 million in the example above).

Indexed UL offers the best illustrated performance at the cost of the greatest downside risk. Illustrated crediting

rates are usually based on applying the current, non-guaranteed equity participation limits of the policy to

historical market data. Carriers and practitioners have gone through great lengths to justify returns using

historical figures but have simultaneously neglected to show historically accurate interest rates in premium

financing proposals. As interest rates have fallen, practitioners have also sought to illustrate ever increasing

spreads by using aggressive and relatively untested ways to access the short-term, low-rate credit markets via

complex, multiparty and highly market sensitive financing arrangements. The lack of historical justification for

constant illustrated loan rates less than historical LIBOR in conjunction with hyper-aggressive financing strategies

to illustrate even lower rates creates additional layers of risk and potential downside. Clients and producers

should be extremely wary of any financing strategy that claims interest rates at a rate lower than historical LIBOR

for the life of the contract. The obvious, common sense question arises if the claims are accepted – if this

financing strategy is so good, why aren’t you, the provider, marketing this as a leverage tool for a myriad of assets

besides life insurance? The reality is that the arrangements are often fraught with loan fees and undisclosed risk.

Furthermore, as noted in Hedging Strategies for Indexed UL Products, there is little reason to believe that Indexed

UL products in the aggregate will outperform their Current Assumption UL twin. A quick litmus test for the

reliance of a particular strategy on outsized Indexed UL performance is to run the strategy with a Current

Assumption UL product at the current crediting rate. If the strategy collapses with a Current Assumption UL,

clients should take extreme caution and be able and willing to post collateral or pay out-of-pocket.

Clients should not, in any way, interpret the use of a carrier’s Indexed UL product for no-outlay premium financing

as an endorsement for the strategy. Many carriers with Indexed UL products are uncomfortable with the strategy

and have created processes to add disclosure and slow or stop the sales process. Other carriers have designed

their Indexed UL product to specifically deter premium financing sales. Still others have decided not to enter the

Indexed UL market for the sole reason that they do not any potential exposure to financed Indexed UL blowups.

In the event that a carrier directly endorses the accrued interest, no-outlay premium financing with Indexed UL,

producers and clients should not interpret that as a sign of the validity of the strategy. The reality is that the client

will have little recourse to the carrier, the carrier will be profitable regardless of the performance of the strategy

and the carrier representatives are paid to promote strategies that generate sales. Life insurance companies have

a long and storied history of directly or implicitly supporting strategies that worked on paper but flopped in reality

(see: vanishing premiums, thin-funded VUL at a 12% illustrated rate, current assumption premium financing,

stranger owned life insurance, UL at funded at 12%, various tax plays and many others). Carriers generally do an

excellent job of protecting themselves from the downside of a failed sales strategy. Indexed UL products are no

exception given that the average Indexed UL product has substantially higher charges than the average Current

Assumption UL products, even within a particular carrier’s product portfolio. Instead of viewing an endorsement

of financed Indexed UL as a validation of the strategy, it is my opinion that it should be seen as an indication of a

carrier’s lack of due diligence and willingness to accept business that its peers view as potentially problematic for

both their reputation and finances. Likewise, the fact that much of the Indexed UL being sold in the high-end

market is premium financed is not an indication of the validity of the strategy either. The strategies listed above

sold much premium before they unwound and presented massive liabilities to the industry and its clients.

Summary

Premium financing for the purpose of leveraging returns over the long-term hinges on a sustainable arbitrage

between policy returns and market loan rates. The crossover point between the returns from premium financing

and paying premium out-of-pocket occurs at the point where the loan costs (including fees) fall below the policy

rate of return. Leverage, in this sense, does not change the fundamental return profile of the life insurance policy.

It simply amplifies both positive and negative results.

No Lapse Guarantee UL products offer the closest thing to a straight swap between the loan rate and the policy

rate of return. NLG products tuned for maximum IRR on the death benefit rarely have cash values to offset the

policy loan, thereby requiring the client to post collateral that generally equals the premiums paid into the

contract. Illustrated returns should be reduced by the direct and opportunity costs of posting large amounts of

collateral. Current Assumption UL does not generally offer a means to arbitrage cash value returns between the

loan rate and the policy crediting rate but does allow for collateral offset at the expense of death benefit IRR.

Indexed UL purports to provide an opportunity for arbitrage due to lax illustration regulations that allow for

illustrated crediting rates well in excess of current loan rates. As such, practitioners have focused on Indexed UL as

a vehicle for no or little out-of-pocket insurance. This practice has the potential for upside but at the cost of

substantial downside risk. Financing Indexed UL with the expectation of no cost to the client is the riskiest form of

premium financing on the market because it so heavily depends on unproven assumptions and the margin of

error is nil – everything has to work perfectly for it to do what the agent claims it will do.

Any client entering a premium financing arrangement with the goal of long-term financial arbitrage should be well

aware of its theoretical and practical implausibility. On theoretical grounds, both the life insurance policy and the

swap instrument are based on the same type of asset. Carriers generally use fixed income assets to hedge their

life insurance liabilities and individual loans are fixed income assets. Non-guaranteed product performance is

reduced by policy charges associated with mortality, distribution costs, carrier overhead and profit. Guaranteed

products may offer the opportunity to swap returns effectively but the writing carrier would have made a

catastrophic bet on interest rates on the process by essentially guaranteeing policyholders far more than it could

actually earn over the long-term in the fixed income process. Practically, leverage in premium financing

arrangement extends to more than just financial instruments. Premium financing illustrations are shown in a

static world where variables don’t change. The reality is that collateral may be needed for more immediate

concerns than life insurance, the carrier gets downgraded and the bank calls the loan, the carrier decides to take

profit on the product, the bank may not renew the loan and a variety of other situations. Even if premium

financing could have worked in a static world, the volatility of the real world almost always causes unexpected

problems that undermine the arrangement. In short, premium financing to achieve financial arbitrage offers the

possibility for upside with an extremely large and tangible downside.

On a final note, this paper does not address short to mid-term premium financing in estate planning for large,

illiquid estates as a means to defer or reduce gift taxes. The illustrations and sales practices for premium financing

arrangements with funded loan exit strategies are categorically different than long-term, arbitrage-driven

strategies. In the former, the premium financing arrangement is a means to an end. In the latter, premium

financing is both end and means.